By Steven Weiser
Steven Weiser is a tax lawyer with a practicing focusing on issues relating to foreign nationals. His contact information and information on his practice can be found on his web site at www.lw-law.com.
The United States is exceptional among developed countries in that it taxes its citizens on their worldwide income, even if its citizens are living abroad and have no other ties to the U.S. Similarly, the U.S. also taxes immigrants, whether naturalized citizens or not, on their worldwide income (with limited exceptions), regardless of where such income is earned. Many other countries, particularly those in Europe, limit the taxation of income earned by their citizens and resident aliens only to income derived from sources within the country. This territorial system of taxation differs in many ways from the U.S. worldwide system of taxation.
Since many immigrants and temporary visa holders are unfamiliar with the U.S. worldwide system of taxation, and may not be aware of their obligations and responsibilities with respect to U.S. taxes, this column will review the U.S. tax laws as they apply to such individuals. An analysis of the U.S. tax laws would require much more time and space than a single article can provide. Therefore, each month we will focus on a different aspect of the U.S. tax laws as they may apply to immigrants and temporary visa holders. We begin with a review of the various tests for determining whether a non-citizen physically present in the U.S. is a “resident alien” or “nonresident alien” under the U.S. tax laws.
As stated above, the U.S. subjects its resident alien individuals to taxation on their worldwide income. This contrasts sharply with nonresident aliens, who are only subject to taxation on certain types of income earned from sources within the United States. Resident and nonresident aliens are also subject to two different methods of taxation. Resident aliens pay tax on a “net basis,” meaning that such individuals are entitled to certain deductions from income in determining their tax liabilities. Nonresident aliens are generally subject to taxation on a “gross basis,” whereby the gross amount of income from sources within the U.S., not effectively connected with a U.S. trade or business, is subject to a flat 30% rate of tax.
Under the Internal Revenue Code of the U.S., an immigrant or temporary visa holder is classified as a resident alien if he or she meets (i) the lawful permanent resident test, (ii) the substantial presence test or (iii) such alien elects to be treated as a resident. The lawful residence test is fairly straightforward in its application; an individual satisfies this test if such individual has been lawfully accorded the privilege of residing permanently in the U.S. as an immigrant and such status has not been revoked. In other words, the lawful permanent residence is satisfied if an immigrant has obtained a green card (hence, this test is also known as the “green card test”).
Substantial Presence Test
The substantial presence test is a bit more complicated in application. A temporary visa holder is treated as a resident alien if such individual is present in the U.S. (i) for at least 31 days during the current year, and (ii) for a total of 183 “adjusted” days during the current and two preceding calendar years. For purposes of applying the 183-day test, a day of presence in the U.S. during the current year counts as a full day; a day of presence in the preceding year counts as 1/3rd of a day; and, a day of presence in the second preceding year counts as 1/6th of a day. This can best be summarized through the following example:
X, an alien individual, is present in the U.S. for 122 days during 2000, 122 days during 2001, and 122 days during 2002. X was not a permanent lawful resident of the U.S. during any of those years and was not present in the U.S. in any year prior to 2000.
X is not a resident for 2000 because X is present on only 122 days during that year and the preceding two years. X is not a resident for 2001 because the total period of residence for 2000 and 2001 is 162 2/3 days (122 days in 2001, and 40 2/3 days in 2000). X is a resident for 2002 because she was present in the U.S. for at least 31 days in 2002, and was in the U.S. for 183 days during 2002 and the preceding two years (122 full days in 2002, 40 2/3 days in 2001, and 20 1/3 days in 2000).
For purposes of counting days an individual is considered present in the U.S. if that individual is physically located in the U.S. at any time during that day, no matter how brief in time. Additionally, fractions of days that result from multiplying days of presence in the first or second preceding years by 1/3rd and 1/6th are not rounded up to one. Finally, the U.S. includes territorial waters and air space above the U.S. for purposes of applying this test.
Substantial Presence Test – Closer Connection Exception
An individual satisfying the substantial presence test, may nevertheless, be treated as a nonresident if three conditions are met. First, the individual must be present in the U.S. for less than 183 days during the current year. Second, the individual must maintain a tax home in a foreign (non-U.S.) country during the current calendar year. Third, the individual must have a closer connection to the foreign country in which the tax home is maintained than to the U.S. This “closer connection exception” is not available to an individual who has an application pending for adjustment of status during the current year, or has applied for permanent resident status during the year.
A “tax home” must be in existence for the entire calendar year for which the closer connection is claimed. An individual’s tax home is generally considered to be located at the individual’s regular or principal place of business, or if none, the individual’s regular place of abode. Additional facts and circumstances that tend to indicate a closer connection with another country include the location of a permanent home (such as a house or apartment), location of family, location of social, cultural or religious organizations, and the country of residence designated by the individual on forms and documents. Because of the subjective nature of the closer connection exception it is not recommended that this exception be relied upon to avoid U.S. residence status, if possible. Nevertheless, those individuals claiming a closer connection with another country should file Form 8840 with the Internal Revenue Service (Philadelphia Service Center).
Substantial Presence Test – Exempt Individuals
Special rules exclude certain days of presence from the substantial presence test. Most notably excluded are days on which an individual is present as an “exempt individual.” Exempt individuals include those present in the U.S. as foreign government-related individuals, certain teachers, trainees or students, and professional athletes temporarily in the U.S. to compete in charitable sporting events. To verify exempt individual status Form 8843 should be filed with the Internal Revenue Service (Philadelphia Service Center).
A foreign government-related individual is someone present in the U.S. (1) due to his or her diplomatic status; (2) by reason of a visa representing full-time diplomatic or consular status; or (3) as a full-time employee of any public international organization that the President of the United States has designated as being entitled to enjoy certain privileges. Immediate family members of foreign government-related individuals are also treated as foreign government-related individuals.
A teachers, trainee or student is an individual admitted temporarily in the U.S. as a nonimmigrant under specified provisions of the Immigration and Naturalization Act, more particularly, “F,” “J,” “M,” and “Q” visa holders. The individual must substantially comply with the terms of such visas. Failure to comply with the terms of these visas, or engaging in activities considered prohibited by the Immigration and Naturalization Act can result in the loss of exempt individual status. Furthermore, the Internal Revenue Service has been granted the power to make an independent assessment as to whether an individual has complied with the terms of the individual’s visa. Unauthorized employment or not being engaged in a course of full-time study may be treated by as a failure to comply with the individual’s visa requirements even if the Immigration and Naturalization Service has not sought to revoke the individual’s visa. Family members of individuals qualifying as teachers, trainees and students temporarily present in the U.S. are themselves treated as teachers, trainees and students.
An individual may not exclude days of presence as an exempt teacher or trainee if the individual has been exempt as a teacher, trainee or student for any part of two of the prior six calendar years. In the case of a temporary “F,” “J” or “Q” visa-holder whose compensation is paid by a foreign employer, the preceding sentence is modified by providing that the individual may not exclude days of presence if the individual has been exempt as a teacher, trainee or student for any part of four of the prior six calendar years.
Y is temporarily present in the U.S. during the calendar year as a teacher. Y holds a “J” visa, and has not received compensation from a foreign employer. Y was treated as an exempt student for two of the prior six calendar years. Even if this is the first year that Y seeks exempt individual status as a teacher, Y will not be an exempt individual because Y was exempt as a student for at least two of the prior six years.
Finally, an individual cannot exclude days of presence as an exempt student if the individual has been exempt as a teacher, trainee or student for any part of more than five calendar years, unless the approval of the Internal Revenue Service is obtained.
Substantial Presence Test – Exempt days
Certain additional days are excluded from any calculations under the substantial presence test. These include days during which an individual is prevented from leaving the U.S. due to a medical condition, days on which a regular commuter residing in Canada or Mexico commutes to and from employment in the U.S., days on which an individual is in transit between two points outside the U.S., and days on which an individual is temporarily present in the U.S. as a regular member of a crew of a foreign vessel engaged in transportation between the U.S. and a foreign country.
Z, a Canadian citizen, owns a residence in Toronto. On January 1, 2002, Z begins working in Niagra Falls, New York, commuting from home to his place of employment six days a week. Although X is physically present in the U.S. approximately 300 days during 2002, none of these days apply in calculating whether the substantial presence test is met. Z is not a resident for U.S. income tax purposes.
A regular commute exists if the individual must travel from her residence to the place of employment more than 80% of the workdays in the current year. A “commute” is defined as travel to and from employment within a twenty-four hour period.
An individual is treated as not being present in the U.S. if such individual is present in the U.S. for less than twenty-four hours and is transit between two points outside the U.S. “In transit” includes activities related to completing travel to another location. If an individual attends a business meeting while in the U.S. the day is no longer exempt. Similarly, a day present in the U.S. as a member of a vessel engaged in transportation is not an exempt day if such individual conducts business in the U.S. on such day.
Election To Be Treated As A Resident
If an individual fails both the “green card” and substantial presence tests, the individual can make an election to be treated as a resident. To qualify for the election the individual must not have been a resident during the prior calendar year and must be a resident under the substantial presence test for the following calendar year. The individual must also meet several minimum presence tests during the year of election as well.
Manipulation of Residency Rules
The Internal Revenue Code contains a provision prohibiting individuals from manipulating the residency rules so that residency status freely changes from year to year. Special tax rules apply if the following three conditions are satisfied: (1) the individual meets the green card test, the substantial presence test, or an election is made to be treated as a resident for at least three consecutive calendar years; (2) the individual then becomes a nonresident; and (3) the individual then becomes a resident before the end of the third year after the initial residency period terminated.
If residency status changes during a year the individual effectively has two tax years, one as a nonresident and one as a resident. If an individual acquires a green card during a year (but does not meet the substantial presence test) resident status begins on the first day of U.S. presence as a lawful permanent resident. Similarly, if the substantial presence test is met, residency generally begins on the first day of U.S. presence. In the case of an individual making the election to be treated as a resident, the residency starting date is the first day of the calendar year of which the individual is treated as a resident.
If an individual expects to become a U.S. resident, the individual may consider accelerating the recognition of income if the effective rate of the foreign tax is less than the rate imposed by the U.S. In particular, consider recognizing taxable gains if the foreign jurisdiction does not impose a tax on capital gains. Such individuals should also consider restructuring their foreign business and asset holdings to avoid subjecting any income earned thereon to U.S. income taxes. The reverse strategies should be considered if an individual is giving up U.S. residency status.
Application of Tax Treaties
If a temporary visa holder or immigrant is treated as a U.S. resident and is also treated, pursuant to a tax treaty between the U.S. and a foreign country, as a resident of that foreign country, the residency rules contained in that treaty apply. These treaties contain several “tie-breaking” provisions that determine which jurisdiction has primary taxing authority over the individual (in other words, these provisions provide rules for determining the one and only jurisdiction of which the individual is considered a resident). If the individual is determined to be a resident of the foreign country for treaty purposes, and the individual claims the benefits of that treaty, the individual is treated as a nonresident of the U.S. for income tax purposes. Some treaties also contain special rules governing the residency of certain qualifying individuals (e.g., athletes).
In summary, residency status under the U.S. tax laws is important for purposes of determining the extent to which those laws apply to an individual. U.S. citizens and residents are subject to U.S. income taxes on their worldwide income. U.S. nonresidents are only subject to U.S. income taxation on income derived from U.S. sources that are not connected with a U.S. trade or business. Noncitizens holding a green card are treated as a residents of the U.S. (unless treaty benefits are claimed), while those physically present in the U.S. for at least 183 days over the current and prior two years (with at least 31 days of presence occurring during the current year) are also treated as residents unless one of several exceptions apply. The first exception applies for those individuals with a “closer connection” to another country. Other exceptions allow certain “exempt individuals” to exclude certain days of presence from determining whether the 183 day test is satisfied, or to exclude certain exempt days for presence due to medical conditions, commuting between Canada or Mexico and employment within the U.S., or days in transit between points outside the U.S. Lastly, an alien individual may elect to be treated as a resident provided certain conditions are satisfied.